US vs Eurozone Weakness

by Ashraf Laidi
Jul 25, 2008 17:33

One day after US existing home sales showed further declines, RealtyTrac reports a 121% increase in the number of home foreclosures in Q2 compared to a year ago, and a 14% rise from Q1 of this year. About 740,000 properties are estimated to have entered the foreclosure process, the most since records began in 2005. The surge in foreclosures accelerates the downward spiral in house prices, thereby eroding homeowners equity and further exacerbating the value of mortgages.

This is one of the many transmission mechanisms contributing to the corrosion in the value of Fannie Mae and Freddie Macs portfolio and weighing on their stocks and bonds held by US and foreign investors. Preliminary Q2 GDP figures from the UK showed a 1.6% increase, the lowest since 2005. This weeks flood of poor European economic figures has contributed to increasing political and market pressure on the European Central Bank to begin easing interest rates.

We disagree with the notion that emerging weakness in Europe would be a reason for a 5-7% decrease in the EURUSD exchange rate . Rather, such weakness is an obstacle to further record highs in the euro against the dollar. There are 3 main general reasons to this assessment:

1) The weakening macroeconomic picture in the US continues to reach far beyond housing, extending to rising unemployment, falling consumer demand and confidence, eroding purchasing power and declining industrial production. The persistent increase in US unemployment rate is a stark reminder than no rate hikes are in the works before the jobless rate drops by at least 0.7-1.0 point.

2) Increased market turmoil remains despite the recent improvement in banking stocks, as corporate earnings have mostly missed estimates. Consequently, the questionable future of Fannie and Freddie raises important questions about future foreign demand of these securities. Foreign purchases of bonds issued by agencies fell to 35% of total net flows in 2007 from 35% in 2006.

3) Eurozone's increasing slowdown is largely limited to cyclical plain vanilla macroeconomic dynamics such as consumer demand/confidence, employment and manufacturing orders. Despite sub-prime related losses with some European insurers, the problems of homeowners negative equity and foreclosures have not caused a drag on demand as the case has shown in the US . As for Spain's housing recession, its repercussions for consumer spending have simply not triggered a mortgage crisis.

Neither the macroeconomic woes nor the ensuing bear market in Eurozone bourses has posed ominous questions for the foreign financing of Eurozone deficit, because the deficit remains inconsistent. Contrary to the UK , the Eurozone remains a net provide of global capital rather than a net borrower.

The foreign exchange implications of these analyses are also enforced by the continued (but gradual) diversification in central bank and sovereign wealth fund currency portfolios, into assets denominated in euro, sterling and East Asian currencies.

EURUSD Euro was initially propped by an 8-year high in German import price growth due to mounting energy prices. Import prices showed a 1.5% increase, which translated into a 8.9% increase for the year ending in June. The figures outpaced expectations of a 1.0% m/m and 8.4% y/y increase.

The single currency was also supported by comments from ECB's Klaus Liebscher (Austrian cen bank) indicating that the ECB has more room for maneuver on interest rates, adding that it is better to act preventively. The euro was especially boosted by Liebschers stating that the central bank was from giving the "all clear" on inflation. Such comments have contributed to further flattening in the Eurozone yield curve, keeping out any odds for a rate cut this year. EURUSD appears to have found a bottom at $1.5630, which stands just below the 50% retracement of the 1.5302-1.6028 move. Key support remains at 1.5580, while any protracted upside faces resistance at 1.5760.

We warned yesterday about the onset of a reversal in EURJPY towards the 168 yen target from 169.95 high, but the pair has limited its losses to 168.53. We expect declines towards 168.20 and 167.50.

USDJPY Japan s CPI rose1.9% y/y in June, in line with consensus market forecast, while the core CPI rose 1.5%, the highest since January 1998. Core CPI excludes food items but not oil prices. Although rising Japanese inflation has been mainly attributed to spillover of energy prices rather than increased demand, the impact should contribute to further pushing up bond yields and compress US-Japan yield spreads. Adding the effect of risk appetite to that of yield spreads, the prospects of prolonged yen gain remain solid. Despite yesterdays Wall Street sell-off, we expect renewed advances in the main indices towards 1,310 and 11,800-11,900 in the S&P500 and Dow before the bears take over. Regaining the 107.50s, USDJPY is seen capped at 108.0 and 108.30, with support climbing to 106.

GBPUSD Preliminary Q2 UK GDP rose 0.2% q/q and 1.6% y/y due to contracting manufacturing and construction as well as the emerging bank slump. UK GDP is expected to reach a 15-year low of 1.5% in 2008, compared to estimates of 1.3% for the U.S. 1.7% for the Eurozone and 1.5% for Japan . The ensuing volatility in sterling pairs remain in function of the alternating evidence between rising inflation and falling business activity, which is also amplified by data in other currencies. GBPUSD faces key resistance at 1.99850, which is the 50-day moving average as well as the 61.8% retracement of the move from the 2.0074 high to the 1.9815 low. Downside target stands at 1.9930 and 1.9900.

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